July 22, 2011
Most believed that quantitative easing was going to bring on raging inflation as the Fed pushed first 1.3 trillion dollars, then another 600 billion dollars into the economy. The dollar was supposed to fall out of bed and it was expected that interest rates would either rise or fall substantially. My readers know that after both QE1 and QE2, I said that beyond a small increase in inflation, it would prove to be neutral.

What do the stats say now that QE2 has ended?


TBT, the ETF which tracks long term interest rates, was 32 at the start of QE2 in November. It traded at 32 this week. The USD was 75 at that time and is about 75 now. Inflation rose from .08% to 3.6% as expected. In the same period the GDP fell from 3.5% to 1.8%, while home prices declined, and stocks rose.


The purpose of QE2 was to head off a possible deflationary trend. That it did. Inflation had declined quickly from around 3 to 4% down to only .08% before the Fed stepped in. The downside to QE2 is that as planned, inflation is back at 3.6%. The possible upside being the prevention of a Japanese style deflationary recession, but that’s impossible to know for sure.


Whatever your views of the Fed's actions, I want to focus on one aspect of it. Most commentators and economists stated openly, and often, that the Fed was buying up 70% of the Treasury’s paper at the weekly auctions in an attempt to lower interest rates. This was most loudly voiced by Bill Gross and his colleagues at PIMCO.


PIMCO, the largest bond buyer in the world (after the Fed), sold their position of Treasury bills. Why? They feared the end of Fed purchasing would lead to higher interest rates. Since that time the ten year bond rate has fallen from 3.5% to 2.9%. Now I ask you, how is it possible that rates have fallen dramatically when the two largest buyers of bonds are absent as bidders?


There is only one possible answer. PIMCO, and all others that espoused this view, were dead wrong. The fact is that the Fed is prevented by law from buying any paper auctioned by the Treasury. They never participated in the auctions in the first place—the Fed bought only in the secondary market—not at the Treasury auctions. That is why the Fed’s ceasing to buy had no effect on interest rates whatsoever.


The secondary market is made up of trillions of dollars of paper, and not very susceptible to government influence. The Fed’s actions were, in effect, lost in such a huge market. Fed purchases went through a group of independent brokers with the money deposited in the broker’s accounts within the commercial banking system, and then held as reserves until lent out. The idea being that if the banks lent that money out it would become active money chasing goods--pushing up prices. In reality, the banks lent out only a small portion of the new money printed by the Fed and the new money never chased goods, which is why it never had a substantial impact on inflation or on interest rates. Both have remained low to moderate.

Here are the official steps of quantitative easing by the Fed according to Wikipedia:

  1. The central bank has previously targeted an extremely low rate of interest, near or at zero percent. 
  2. The central bank credits its own bank account with money it creates electronically.
  3. The central bank buys government bonds (including long-term government bonds) or other financial assets, from commercial banks or other financial institutions, with the newly created money.
MI and M2 are the measures of the money supply. They have increased for a year – but not to the degree that new money has been created. This put a slight upward pressure on inflation as intended. But because the money created by the Fed was never lent out freely, no runaway inflation resulted. The money supply has stayed within limited parameters and the velocity of money has remained low. The result? Inflation and interest rates never became a threat to the economy as many predicted. Not before QE, not during QE, and not after QE.


Many pointed to the dollar as the real target of the Fed. They claimed the USD would crash and burn. Again let's look at the facts. The dollar was 75 against a basket of currencies at the beginning of QE2 in November. Again, it is about 75 today—neutral (See $USD for a current quote).


If a falling dollar wasn’t to blame for the spike in commodity prices, what was? Weather, labor strikes, uprisings and oil disruptions in the Mid East, and hoarding. All these combined to push up prices of oil, food, and various other resources – world wide. So unless we see another round of these factors I think we’ve seen the end of that move in commodity prices and will see inflation fall for the remainder of the year.


QE2 will eventually be remembered by economic historians for what it really was; an anti-deflationary policy designed to avoid the kinds of mistakes made going into the Great Depression here in the US, and by Japan during its real estate boom which led to 30 years of de-leveraging and deflation. If inflation is low a year from now, I think the nation owes Mr. Bernanke and the Fed members of the Board of Governors an apology – and a debt of gratitude.


Market Update:


There was a lot of noise in the markets this week as the debt crisis in Europe grabbed headlines along with the debt talks in the US. The markets went up and down, and down and up, and in the end we ended up just spinning our wheels. The day to day excitement in the end was part of a rather boring week…


It reminds me of the movie "The Karate Kid,” where Mr. Miagi instructs his protégé to repeatedly, "wax on, wax off, wax on, wax off." All week we had "risk on, risk off, risk on risk off." Enough!


Let’s focus on a few things that are important to the markets. I picked this off the wires last night:


According to drafts of a statement that was being discussed earlier in the evening by the 17 euro zone heads of government, banks have agreed to take part in several programs to reduce Greece’s debt, including plans that would mean exchanging existing bonds for new bonds with lower interest rates and longer maturities.


In other words, governments are going to do what they have been doing for decades. They are going to default on their creditors and call it "a resolution of the debt problem.” I know enough about history to know that when push comes to shove, debtors make out at the expense of creditors. It is usually the creditors that bare the brunt of debt problems, and there will be no exception in today's world.


In 1973, and again in my book, The New Gold Standard, I wrote a section called Amortize or Default. It lays out the present scenario of either extending loans at lower interest rates, or devaluing the national currency. Both are forms of default – which is the evaporation of money and therefore, deflationary in nature.


Jon Nadler posted this interesting piece today on Kitco: China is coming under increased suspicion. 


"The clock also appears to be ticking for China’s central government as far as it having to take pre-emptive action to avert a tidal wave of bankruptcies that some experts say could cripple its (and the global) economy. A high profile lobby, the All China Federation of Industry and Commerce has urged Beijing to concentrate on doing something in order to prevent some 7.5 million businesses in the country from going belly up as they face tightened credit and rising inflation conditions. Such a mushroom cloud of business failures would clearly have a deleterious impact on China’s economy, and perhaps more than just that. China’s property bubble is indeed shaping up to have potential ramifications that are just now beginning to crystallize, and they appear to be anything but confidence inducing."


Meanwhile, Caterpillar fell dramatically today, on news that China is slowing. That is old news to readers here, and confirmation of a continuing trend, but get this:


There is a report that Yahoo is now only a shell of a company. It is said that their entrance into China and mandatory association with the government led to the complete pirating of the companies software and trade secrets. These are now sold by China at a subsidized lower price. Yahoo was raped. It now is questionable whether it is even a viable company.


And in an even more blatant act of theft, CNBC and Fox News just showed an Apple Store in China that is a knock off. In other words, although everything in the store looks like Apple products, and while they feature Apple logos and trademarks, they are all pirated and copied! The store is prominently featured on a busy China street. Apple claims to know nothing about its existence. Neither does China. CNBC claims others are popping up all over.


On the other side of this story is that Apple has just reported over 76 Billion in cash reserves, the largest cash chest in history for any company in any country in history. Apple has enough cash to bail out Greece! But why would Apple want Greece when it can buy Netscape or Facebook. On the other hand, why would China want to bail out Greece when it could possibly steal Netscape or Facebook? Such is the world we live in today.


Next week look for "wax on, wax off" again.


No change in the portfolio.